Topics in Environmental Economics: Taxes, Emissions Trading, and Other Topics in the Economics of Pollution

Guest Lecturer: Hans Zigmund

DePaul University

PPS 329/359 Special Topics: Applied Urban and Environmental

Economics

Purpose

To provide students with the tools of economic theory for analyzing environmental issues from an economic perspective.

To that end this lecture will be largely theoretical with relevant applications in the second half of the talk.

Outline Macroeconomics (Growth Theory) Microeconomics Theory

Utopian Capitalist View Cost Benefit Analysis Adjustments at the Margin (Taxes, Subsidies, and Markets)

Microeconomics applied to policy Kyoto Protocol European Union Emission Trading Scheme (ETS) Alternative International Agreements Boulder Carbon Tax

Economic Growth

Increase GDP/Capita (Economic Output) Factors of production:

Land (L)Labor (N)Capital (K)

Economic output requires the exploitation of natural resources.

Areas of Government Intervention

Reduce Pollution (Today’s area of focus) Reduce Depletion of Natural Resources Manage Public Lands Compensation from Natural Disasters

Environmental Perspective on GDP

Focus of economic growth is on increasing GDP/capita.

Hides negative impact on ecosphere of producing goods and services.Pollution related healthcare costsExxon Valdez clean up $2.2bn

Environmental Perspective on GDP

GDP does not account for the degradation of natural resources.ErosionWater PollutionExhausting Mineral ResourcesDepleting Fisheries (until possibly too late)

Environmental Perspective on GDP

Hides negative or underestimates some positive effects.Energy efficient light bulbs and appliances.Fuel efficient cars.

Index of Sustainable Economic Welfare (ISEW) and Genuine Progress Indictor

(GPI) Created by Herman E Daly and John Cobb Jr.

(1989) and Philip Lawn (2003) Adjusts GDP/capita for

Income Distribution Depletion of natural resources Loss of wetlands Loss of farmland from soil erosion and urbanization. Cost of air and water pollution Estimate of long term cost of global warming.

Utopian Capitalist View: Pareto Optimality

Edgeworth Box Exhausting Gains On Trade Conditions of Pareto Optimality

You cannot make one party better off without making another worse off.

Parties involved in exchange bear the full true cost of the transaction.(no externalities)

Cost Benefit Analysis: Pollution Abatement

Seek out the point that minimizes both the cost of abatement and environmental damage costs (or maximize environmental benefit).

Total Cost curve is minimized at the point of intersection.

$1 in abatement cost = $1 in damage cost control or environmental benefit.

Cost Benefit Analysis: Pollution Abatement

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Amount of pollution abatement

Socially optimum

amount of

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abatement

Damage Cost

Abatement Cost(EnvironmentalBenefit)

TC

Cost Benefit Analysis: Pollution Abatement

On the right side, spend too little leads to high environmental costs.

On the left side, spend too much and it trade offs will have to be made with other social programs such as public health.

Regulatory Approach

Historically the regulatory approach has been effective.

Example:Automobile emissions and MPG standards.Leads to reductions in Carbon Monoxide

emissions and other pollutants. Is the regulatory approach the most efficient?

Regulatory Approach Two Firm Model Marginal Cost/Marginal Benefit and

inefficiencies. Because hypothetical firm A and firm B to

abate the same quantity under different marginal cost structures, firm A may abate in excess of marginal benefit while firm B may abate less than optimal.

Regulatory Approach

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Amount of pollution abatementQR

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IIDamage Per Unit

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MCA

MCB

Regulatory Approach

Area I represents abatement cost in excess of benefits for firm A.

Area II represents opportunity cost loss of firm B for stopping abatement while marginal benefits were still greater than marginal costs.

Adjustments at the Margin: Pollution Taxes

In efficient markets P = MC. True only when firms marginal cost equals the real

cost of the next unit of production. If pollution create costs on society not incurred by

business (externality), then an over allocation of resources into production will occur.

Taxes can correct for this over allocation by internalizing the externality.

Adjustments at the Margin: Pollution Taxes

Spillover

costs

OverallocationCorrected

P

Q0 QeQ0

MCt

MC

DTAX

Pe

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Adjustments at the Margin: Subsidies

R&D that leads to reduction in pollution has positive societal benefits.

R&D will only be invested in if profitable. Subsidizing R&D can reduce the time it takes

to develop new technology. R&D doesn’t always generate a outcome on

the income statement. The subsidy helps offset the risk of investment.

Adjustments at the Margin: SubsidiesP

Q

R&D Subsidy toproducersDecreases marginal

cost

UnderallocationCorrected

Q0Qe0

MCs

MC

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Adjustments at the Margin: Markets for Pollution Rights

Politically more palatable to business because it relies on markets rather than taxes for corrections.

Firms (such as public utilities in the market for SO2 ) receive a fixed number of pollution allowances.

These credits can be sold and bought on the CBOT. If firms use more pollution than they own credits for they

pay a fine.

Adjustments at the Margin: Markets for Pollution Rights

Pric

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of p

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right

Quantity of SO2 pollution rights (millions of tons)8 9 10 11 12 13

$2000

$1000

D 2007

2010

S = Supply

of SO2

pollution rights

Allowance Trading Basics An emissions "cap": A limit on the total amount of

pollution that can be emitted (released) from all regulated sources (e.g., power plants); the cap is set lower than historical emissions in order to reduce emissions.

Allowances: An authorization to emit a fixed amount of a pollutant.

Measurement: Accurate tracking of all emissions. Source:http://www.epa.gov/airmarkets/trading/basics.html

Allowance Trading Basics Flexibility: Sources can choose how to reduce

emissions, including whether to buy additional allowances from other sources that reduce emissions.

Allowance trading: Sources can buy or sell allowances on the open market. Because the total number of allowances is limited by the cap, emission reductions are assured.

Compliance: At the end of each compliance period, each source must own at least as many allowances as its emissions.

Source:http://www.epa.gov/airmarkets/trading/basics.html

Trading the Right to Pollute

The NOx Budget Trading Program is a market-

based cap and trade program created to reduce emissions of nitrogen oxides (NOx)

from power plants and other large combustion sources in the eastern United States.

Source : http://www.epa.gov/airmarkets/progsregs/nox/sip.html

Trading the Right to Pollute Market-based sulfur dioxide (SO2) allowance trading

component of the Acid Rain Program Utilities regulated under the program, decide the most

cost-effective way to use available resources to comply with the acid rain requirements of the Clean Air Act. Purchase pollution allowances. Switching to lower sulfur fuel. Reduce emissions by employing energy conservation

measures

Source: http://www.epa.gov/airmarkets/trading/factsheet.html

Success of Acid Rain Program which includes trading pollution allowances

Reduced SO2 emissions by over 5.5 million tons from 1990 levels, or about 35 percent of total emissions from the power sector. Compared to 1980 levels, SO2 emissions from power plants have dropped by more than 7 million tons, or about 41 percent.

Cut NOx emissions by about 3 million tons from 1990 levels, so that emissions in 2005 were less than half the level anticipated without the program. Other efforts, such as the NOx Budget Trading Program in the eastern United States, also contributed significantly to this reduction.

Led to significant cuts in acid deposition, including reductions in sulfate deposition of about 36 percent in some regions of the United States and improvements in environmental indicators, such as fewer acidic lakes.

Source: http://www.epa.gov/airmarkets/progress/arp05.html

Kyoto Protocol Industrialized nations reduce CO2 5 percent from 1990 levels by

2008-2012 compliance period. United States withdrew in 2001. China and India are not required to comply because they are

developing nations. By 2002 Kyoto only covered about 30 percent of global CO2

emissions. Too little too fast. Not enough change to make a difference. Difficult to comply with for countries who experienced substantial

growth in the 1990’s.

European Union Emissions Trading Scheme (ETS)

Kyoto with teeth. Covers half of Europe’s carbon emissions. (8% of global) Each country creates a national allocation plan for specifying

caps on greenhouse gases. Businesses can either reduce their emissions or purchase

allowances from facilities with an excess of allowances. Allowances traded in the ETS are not printed but are held in

electronic account registries set up by Member States and are overseen by a Central Administrator at the EU.

Emissions considered a service under EU’s VAT.Sources: http://ec.europa.eu/environment/climat/emission.htm and Nordhaus, William D. The American Economic Review, “After Kyoto: Alternative

Mechanisms to Control Global Warming” 96(2) May 2006, 31-34

Alternative International Treaty Options Link treaty to specific environmental objectives rather than a

baseline year pollution level. (e.g. temperature, costs, damages) (Nordhaus 2006)

Use an extended time path. Depart gradually from a business as usual pattern becoming more severe over time. (Olmstead and Stavins 2006)

Extend tradable allowances globally. (Olmstead and Stavins 2006) Extend participation beyond industrialized nations to include the

developing world and United States. (Olmstead and Stavins 2006)Nordhaus, William D. The American Economic Review, “After Kyoto: Alternative Mechanisms to Control Global Warming” 96(2) May 2006, 31-34 and Olmstead, Sheila M. and Robert N. Stavins. The American Economic Review, “An International Policy Architecture for the Post-Kyoto Era 96(2) May

2006, 31-34 and

Boulder Carbon Tax Boulder's City Council adopted the goals of the Kyoto Protocol in

2002 to reduce greenhouse gas emissions below 1990 levels by 2012. On November 14, 2006 with Initiative 202, the Climate Action Plan

Tax, the Boulder Colorado city council approved a carbon tax which is applied to residents electric and gas bills.

Average tax for homeowners $1.33/month and Business $3.80/month Estimated energy cost savings from implementing the Climate Action

Plan are $63 million over the long term. Revenue estimated is $6.7 million by 2012, when the goal is to have

reduced carbon emissions by 350,000 metric tons. Source: http://www.ci.boulder.co.us/index.php?option=com_content&task=view&id=6136&Itemid=169 and

http://www.env-econ.net/2006/11/a_carbon_tax_in.html